All Eyes on Fed, but 'Fiscal Cliff' Looms Larger

Markets expect the Fed to announce Wednesday that it will continue buying Treasurys, helping to keep rates low, but the course for near-term interest rates is more likely to be determined by the actions of politicians as "fiscal cliff" talks continue.

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Federal Reserve Building, Washington, D.C.

The Fed is widely expected to extend its monthly purchases of $45 billion in Treasurys but end the concurrent sale of shorter-duration Treasurys that it has been conducting under Operation Twist. Twist expires at the end of the month, and Fed watchers now expect its asset purchases to be rolled into a quantitative easing (QE) program, which will add assets to the Fed balance sheet, unlike Twist. The Fed is currently buying $40 billion a month in mortgage purchases as part of its QE3 program.

"I think the market expects to see, relatively speaking, little change. Probably the amount they buy will continue at $45 billion, but they'll probably stop selling securities at the front end," said David Ader, chief Treasury strategist at CRT Capital.

Ader said yields do have some room to go higher, with the 10-year edging toward 1.70-1.75 percent. But Washington's discussions on the more than $500 billion in expiring tax hikes and automatic spending cuts starting Jan. 1 could be a more powerful driver, and analysts say that if Congress fails to cooperate on a plan for spending and taxes, rates could move toward record lows in a flight-to-safety move. Rates could also move lower if Congress agrees to a plan that is too harsh, with the potential to trigger a recession.

"The cliff looms… If they come out and the deal they constructed takes 1.5 percent or 2 percent away from GDP and we're looking at a flat first quarter and a large negative impact on disposable income, then we're not selling off," Ader said.

If the spending cuts and tax hikes are less severe, then the 10-year yield could move in a range between 1.50-1.55 percent to 1.85-1.90 percent in the first quarter, he said.

Yields moved higher Tuesday, as the Fed started its two-day meeting. The 10-year was at 1.65 percent in the afternoon.

An auction of $32 billion in 3-year notes came at an all-time low yield of 0.327 percent. Direct bidders, including primary dealers, took 24.8 percent of the offering, the highest amount in more than two years.

Ward McCarthy, chief financial economist at Jefferies, said the bond market is bracing for an unusually large amount of issuance in the next two weeks, with $179 billion scheduled across the curve. "Right now it's reacting to supply. This is a relatively standard concession. It's also a 'risk on' day and that tends to hurt Treasurys," he said. Treasury yields move inversely to prices.

On Wednesday, there is a $21 billion 10-year auction at 11:30 a.m. ET, just ahead of the Fed's 12:30 p.m. announcement and 2 p.m.release of Fed forecasts. "There's a whole heap of supply coming into the market in a very short period of time, at a time of year when it's not really clear what the buy side is going to be doing," said McCarthy.

But McCarthy said the market is most concerned about the fiscal cliff issues. "I think we learned something from the really sharp declines in University of Michigan sentiment data Friday and the small-business survey today," he said. "We're getting close enough that at some point, you're going to get people pulling the ripcord, and if they don't do something by Christmas, it's going to be a very ugly last week of the year."

Ader said he expects the Fed to move further down the curve in its Treasury purchases, to durations below the 10- and 30-year securities it is now buying, and some strategists say the Fed could change the mix by boosting its mortgage purchases.

Nomura Americas strategist George Goncalves expects the Fed to add purchases of five-year notes, the same duration of many consumer loans, such as those for autos. "They're willing to buy by printing reserves. They might as well do it efficiently and do it in a way that helps consumer rates," he said.

He said rates have the potential to move lower, but most of that move has already happened.

"I think markets are always good at pricing in heading into an event," he said. "It doesn't mean you wouldn't get a pop that would help substantiate the move. We've been scratching the bottom in rates for a number of months now, aided by the concerns over the fiscal cliff so the Fed's actions were well televised. So that overall helps Treasurys. A lot of it is priced in."

The Fed is unlikely to use this week's meeting to change the way it communicates on interest rates, but that may be something Fed Chairman Ben Bernanke mentions in his 2:15 p.m. quarterly press briefing.

"My base case is they take us off the cliff and then get a long-term deal done by the second quarter of next year. If that's the case, it would help keep rates lower early in the year," McCarthy said. "At least for the time being, it's hard to make a case for rates to go higher. I think we're basically stuck in this low-rate environment for another 12 months anyway. If we were to get a meaningful budget deal, the economy could beat most expectations." A better economy would obviously be a catalyst for higher rates.

Goncalves said the market could still see lower yields, but he said most of the move has probably been made, unless the economy hits the fiscal cliff.

"We had a pretty big move today. There were a lot of steepening-type trades going through," he said.

"Either way, they're easing, so that helps keep rates lower," Goncalves said. "I think they acknowledge that the consistent buying, month in and month out in the last 12 months and lately with the purchase of mortgages, has really improved financial conditions. They're not going to upset the apple cart when they're in the middle of some success."

Besides the Fed, markets will also be watching import prices at 8:30 a.m.